The growing use of collateralised debt obligations, and the speed at which new deals are coming to market, means custodian banks are allocating considerable resources to servicing this profitable seam of business.

Despite numerous credit events and difficult market conditions, the collateralised debt obligation (CDO) market has continued to grow thanks to innovation. Since 1998, the CDO market has experienced an average annual growth rate of 150%.

The average lifespan of a CDO – typically a structured transaction in which a special purpose vehicle is established to sell credit protection on a range of underlying assets – is between seven and eight years, over which time the credit risk and protection must be managed on a periodic and, in some cases, daily basis by the collateral manager. Back-up and support for this management falls increasingly on the custodian banks, which employ specialised teams dedicated to servicing CDOs.

As the leading service provider for CDOs globally, JPMorgan serves as trustee, custodian, paying agent, registrar and transfer agent for all forms of CDOs. Additionally, as portfolio administrator, JPMorgan performs compliance tests and produces trustee reports for investors and rating agencies.

The range of services JPMorgan provides has expanded over the years, from basic agency functions to daily portfolio evaluation and bespoke performance reporting.

Market domination

Having been involved in the CDO market since its inception, the firm estimates that it touches nearly one out of every two CDOs brought to market globally.

Jim Maitland, head of JPMorgan’s Trust Company in Europe, Middle East and Africa (EMEA), which is part of JPMorgan Worldwide Securities Services, says: “When CDOs were first rolled out they were principally securitisations of corporate bonds. The market has since developed to include transactions of various structures and asset types, such as collateralised fund obligations, collateralised loan obligations [CLOs] and synthetic CDOs.

Mr Maitland adds that the structures can be highly complex with a host of different service requirements, and the extent of these activities varies dramatically from one structure to the next. Mr Maitland says: “Each deal has its own bespoke nuances that require corresponding unique servicing requirements and, no matter how large you get, the value comes from being able to respond to each transaction that comes on line.

“We typically fill the fiduciary trustee role and a host of agency related roles, but the real heavy lifting is what we call the portfolio administration role or collateral administrator. The level of services required for a CDO depends very much on the structure and its underlying assets, and importantly whether the portfolio is static or actively managed.

“Static CDOs require basic reporting and agency services, whereas actively managed CDOs can require daily activities including trade substitution and settlement, asset valuation, cash management, and portfolio compliance testing.

Mr Maitland says that the CDO market has seen further evolution with increasingly complicated reporting requirements and the introduction of new service provider roles (such as the ability to support later and uncertificated instruments that have more complex rate calculation/drawdown requirements).

“Additionally, there was an increasing number of hybrid/alternative investment structures [transactions with CDO, market value and hedge fund components] that called for a single point of contact for bundled services, such as fund accounting, valuation, paying agency and collateral administration.”

Leveraged loans continued to be a popular asset class in 2005 as JPMorgan saw a dramatic increase in loan-based transactions, especially in the second half of the year. Mr Maitland adds: “Not only did JPMorgan see a high level of loan transactions, additional valuation services were required with the revival of market-value CDOs [actively traded for asset appreciation]. In fact, 2005 saw the first market-value CLO transaction come to the European market, which we supported.”

The CDO market continues to evolve at a rapid pace. Over the past few years, hedge funds have been making an increasingly large movement into CDO and CDO-type transactions. The use of market-value CDO technology as a financing vehicle for hedge funds is one of the more innovative strategies employed recently.

Mr Maitland says: “As these structures become more complex, increased reporting and valuation requirements are needed to support them. What differentiates the service providers is the ability to provide this information in an integrated manner. The ability to tie in value-added data, such as valuations and services from third parties, delivers the information more seamlessly, more accurately and on a more timely basis.”

The importance of this cannot be underestimated, according to Mr Maitland. He says: “The CDO market continues to evolve and grow at an extremely fast pace. There is a shorter timeframe for deals to be structured and launched – from months to weeks. This puts greater importance on engaging a service provider that can deliver tailored solutions and has the backing of an industrial-strength platform.”

The Bank of New York (BNY), which ranked second in the Thomson Q3 Ranking, sees the CDO market as a tremendous growth opportunity for the bank which acts as a trustee, paying agent, registrar, collateral administrator, and more for CDOs.

Jocelyn Lynch, director of EMEA Global Trust at the Bank of New York, says: “As trustee and collateral administrator our role is much more involved for cash-flow CDOs, as opposed to synthetic CDOs, especially where the collateral is leveraged loans or asset-backed securities (ABS), as most of the work is in the servicing of the collateral.

“There is usually a third-party servicer for a straightforward ABS transaction, but we are effectively the servicer for a cash-flow CDO and it is up to us to ensure that all the cash expected to come in the CDO over its lifespan is anticipated and modelled, accounted for and reconciled, and make sure we are representing the interests of investors as best as possible.”

Compliance issues

The growing complexity of CDO deals is putting increased pressure on reporting. BNY’s dedicated unit uses software to model waterfalls of payment priorities, test compliance, calculate multi-class bond payments, and perform other essential functions with speed.

The bank’s software accepts electronic feeds from most custody and loan servicing systems while handling a wide range of collateral types. Its streamlined information delivery system enables collateral managers to view the same essential account data as the bank’s staff, offering a powerful tool for inquiry, cash management, trade affirmation and problem resolution.

Ms Lynch adds: “There is far more emphasis now on the mezzanine and equity tranches than there was five years ago and when investors are buying into these tranches they expect to have more detailed investor reports, and they expect the accuracy and the frequency of these reports to be better, and the expectations are naturally high.”

In terms of the complexities of the structures themselves there is greater customisation. With every new deal there are slight changes, nuances from different arrangers, and the structures involve the different types of collateral investors are looking for.

“For example, with the spreads being so tight on ABS, investors are looking for some synthetics to be added in to increase the excess spread in the transaction and overcome the reduction in arbitrage opportunities,” she says.

BNY customises its reports, available online, depending on the end-investor. Ms Lynch says: “The different tranches of investors are looking for different things. AAA note holders basically want a summary of what is happening with the deals. Mezzanine and equity investors want a lot more detail. They want to know exactly what cash is going into the portfolio, what the investments are, the diversity of the portfolio, how the various compliance tests are broken down. So what we are typically finding is that we are putting together one set of reports for the more senior-rated note investors and another more detailed set of reports for the mezzanine and equity investors.”

BNY has made a substantial investment with US technology firm Atlantic Information Systems. This exclusive partnership with Atlantic was to set BNY apart from its competitors, as the system is a true multi-currency system. It is able to model the complex hedges associated with European transactions. Says Ms Lynch: “A lot of the CDO systems out there are loan or bond custody systems, which have been tweaked to perform various tests, and others are using separate waterfall systems in order to model the cash flows, whereas we have it seamlessly integrated.”

Star performer

Due to impressive growth and innovation, the CDO market is drawing a lot of attention from players outside the derivatives industry. In a report, “Collateralized Debt Obligations Market”, published in October 2005, Celent estimates that the overall CDO market represents over $1500bn and will grow close to $2000bn by the end of 2006. Says Axel Pierron, Celent analyst and author of the report: “The CDO market has become one of the most profitable markets for investment banks, given diminished IPO and M&A activity. The growth of this market is not going to slow down dramatically, despite various hiccups.”

At this rate of growth, apart from the need to service a higher volume of CDOs efficiently, the onus is going to be very much on the provision of value-added services in order to gain competitive advantage.

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